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April 2013 n Volume 17 n Issue 4

Caveat Emptor: Contractual Indemnification Provisions in Acquisition Agreements and Resulting Acquirer Risk for Unknown Actions of Target FiduciariesB y B r A D l E y r . A r O N s T A m A N D A . T h O m P s O N B A y l I s s

Bradley R. Aronstam and A. Thompson Bayliss practice corporate and commercial litigation in the Delaware Court of Chancery at Seitz Ross Aronstam & Moritz LLP and Abrams & Bayliss LLP, respectively, in Wilming-ton, Delaware. The views expressed herein are those of the authors alone and do not necessarily represent the views of their firms or clients. Contact: [email protected] or [email protected].

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Transactions involving public companies in today’s M&A environment are all but certain to be challenged by target stock-holders.1 At least in part because of this phe-nomenon, targets of acquisitions typically demand that acquirers agree to indemnify their directors and officers for expenses and liabilities incurred in connection with litiga-tion challenging the transaction. Although indemnification obligations embedded in acquisition agreements are creatures of con-tract and can vary significantly, recent cases highlight the nontrivial risk that acquirers may be unknowingly exposing themselves to indemnification obligations that the tar-get itself would be prohibited from provid-ing under Delaware law.

This risk arises in part from the lim-ited scope of Delaware’s statutory restric-tions on indemnification. Section 145 of the Delaware General Corporation Law

(“DGCL”) restricts the ability of Dela-ware corporations to indemnify their own directors and officers for expenses and li-abilities arising out of third-party actions (e.g., stockholder class actions challeng-

A Hard Case Makes Good Law: Meso Scale Diagnostics, LLC v. Roche Diagnostics GmbHBy Jonathan E. Levitsky and Dmitriy A. Tartakovskiy ....10

“Don’t Ask, Don’t Waive”: Standstill Provisions in Light of Recent Delaware CasesBy Scott M. Freeman, Gabriel Saltarelli and Robert J. Higgins .............................................................14

The Uncertain Relationship Between Fiduciary Waivers & the Implied Covenant of Good Faith in Delaware Alternative Entity LawBy Krishna Veeraraghavan and Jason S. Tyler ..............21

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Editorial Board

BOARD OF EDITORS:

BERnARD S. BLACkUniversity of Texas Law SchoolAustin, TX

FRAnCI J. BLASSBERGDebevoise & PlimptonNew York, NY

DEnnIS J. BLoCkCadwalader, Wickersham & TaftNew York, NY

AnDREW E. BoGEnGibson, Dunn & Crutcher LLP Los Angeles, CA

H. RoDGIn CoHEnSullivan & CromwellNew York, NY

STEPHEn I. GLovERGibson, Dunn & Crutcher LLPWashington, DC

EDWARD D. HERLIHyWachtell, Lipton, Rosen & KatzNew York, NY

vICToR I. LEWkoWCleary Gottlieb Steen & Hamilton LLPNew York, NY

PETER D. LyonSShearman & SterlingNew York, NY

DIDIER MARTInBredin Prat Paris, France

FRAnCISCo AnTUnES MACIEL MUSSnICHBarbosa, Mussnich & Aragão Advogados,Rio de Janeiro, Brasil

PHILLIP A. PRoGERJones DayWashington, DC

PHILIP RICHTERFried Frank Harris Shriver & JacobsonNew York, NY

MICHAEL S. RInGLERWilson Sonsini Goodrich & RosatiSan Francisco, CA

PAUL S. RykoWSkIErnst & YoungNew York, NY

FAIzA J. SAEEDCravath, Swaine & Moore LLPNew York, NY

CARoLE SCHIFFMAnDavis Polk & WardwellNew York, NY

RoBERT E. SPATTSimpson Thacher & BartlettNew York, NY

ECkART WILCkEHogan LovellsFrankfurt, Germany

GREGoRy P. WILLIAMSRichards, Layton & FingerWilmington, DE

WILLIAM F. WynnE, JR White & Case New York, NY

CHAIRMAn:PAUL T. SCHnELL Skadden, Arps, Slate, Meagher & Flom LLP New York, NY

MAnAGInG EDIToR:CHRIS o’LEARy

Caveat Emptor: Contractual Indemnification Provisions in Acquisition Agreements and Resulting Acquirer Risk for Unknown Actions of Target Fiduciaries

Although indemnification obligations embedded in acquisition agreements are creatures of contract and can vary significantly, recent cases highlight the nontrivial risk that acquirers may be unknowingly exposing themselves to indemnification obligations that the target itself would be prohibited from providing under Delaware law.

By Bradley R. Aronstam and A. Thompson Bayliss, Seitz Ross Aronstam & Moritz LLP and Abrams & Bayliss LLP (Wilmington, DE) .............................................................................1

From the EditorBy Chris O’Leary, Managing Editor .................................................3

A Hard Case Makes Good Law: Meso Scale Diagnostics, LLC v. Roche Diagnostics GmbH

The Delaware Court of Chancery’s recent ruling in Meso Scale Diagnostics v. Roche Diagnostics reaffirmed the M&A bar’s prevailing view on this issue, holding that, under Delaware law, a reverse triangular merger where the target is the surviving entity generally does not result in an assignment by operation of law of a contract that is held by the surviving entity both before and after the merger.

By Jonathan E. Levitsky and Dmitriy A. Tartakovskiy, Debevoise & Plimpton LLP (New York) .......................................10

“Don’t Ask, Don’t Waive”: Standstill Provisions in Light of Recent Delaware Cases

The Delaware courts have recently scrutinized the use of such “don’t ask, don’t waive” standstill provisions. Recent bench rulings in the Delaware Chancery Court suggest that, because DADW standstill provisions are powerful tools, they should be used only under close supervision by the board of directors.

By Scott M. Freeman, Gabriel Saltarelli and Robert J. Higgins, Sidley Austin LLP (New York) .......................................................14

The Uncertain Relationship Between Fiduciary Waivers and the Implied Covenant of Good Faith in Delaware Alternative Entity Law

A number of class actions challenging mergers and other conflict transactions involving alternative entities recently have been brought in the Delaware Court of Chancery due to an apparent conflict in Delaware’s implied covenant doctrine.

By Krishna Veeraraghavan & Jason S. Tyler, Sullivan and Cromwell LLP (New York) ............................................................21

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©2013ThomsonReuTeRs 3


Busy Days in DelawareEach article in our current issue is concerned

in some manner with recent decisions from the Delaware courts. That said, the topics under con-sideration range far and wide. Our lead article, for instance, examines three relatively recent deci-sions that “highlight the nontrivial risk that ac-quirers may be unknowingly exposing themselves to indemnification obligations that the target it-self would be prohibited from providing under Delaware law. This risk arises in part from the limited scope of Delaware’s statutory restrictions on indemnification.” As the authors Bradley Ar-onstam and A. Thompson Bayliss write, “while none of the cases delved substantively into the issue, all three recognized the possibility that ac-quirers may be able to extend indemnification rights beyond the limits of Section 145.”

This is a critical point, as until the common law limits on director and officer indemnification are better understood, the authors argue that acquir-ers should make clear in agreements that their in-demnification obligations “are limited in scope to conduct that could be indemnified by the target (i.e., those within the province of Section 145),” they note. “Sellers, on the other hand, may seek to impose broader indemnification obligations where possible.”

A more recent case of note is the Delaware Court of Chancery’s ruling in Meso Scale Diag-nostics, LLC v. Roche Diagnostics GmbH. The case challenged a broadly held assumption of M&A practitioners—that the acquisition of a target company through the common “reverse triangular merger” structure does not result in the assignment of the contracts of the target by operation of law or otherwise, as Debevoise & Plimpton’s Jonathan Levitsky and Dmitriy Tarta-kovskiy write.

“The issue is important because while most commercial contracts prohibit assignment with-out the consent of the counterparty, provisions granting a termination right or other remedy in the event of a change of control are less com-mon,” the authors note. (For another excellent perspective on the Meso decision by Sherman and Sterling’s Michael Kennedy, please see the May 2013 issue of our sister publication, Wall Street Lawyer.)

Also, Sullivan & Cromwell’s Krishna Veera-raghavan and Jason Tyler examine what they de-scribe as an “uncertain relationship” between fi-duciary waivers and the implied covenant of good faith in Delaware alternative entity law. As the authors write, “the risk is that Delaware’s implied covenant doctrine “seems” to open a backdoor to fiduciary review that, as the Court of Chancery has described it, is “tempting” to plaintiffs and plaintiffs’ firms. Furthermore, until that backdoor definitively is shut, unaffiliated equity holders have at least a colorable legal theory on which to initiate litigation against alternative entities and those who manage them.”

Finally a trio of Sidley Austin attorneys, Scott Freeman, Gabriel Saltarelli and Robert Higgins, dig into the Delaware courts’ recent scrutinizing of the use of “don’t ask, don’t waive” standstill provisions, and note that “recent bench rulings in the Delaware Chancery Court suggest that, be-cause DADW standstill provisions are powerful tools, they should be used only under close super-vision by the board of directors.”

CHRIS O ’LEARY MANAGING ED ITOR

From the EDITOR



ing acquisitions) to situations where the directors and officers acted “in good faith and in a manner [they] reasonably believed to be in or not opposed to the best interests of the corporation.”2 But Sec-tion 145 only expressly applies to circumstances in which a corporation has agreed to extend in-demnification to its own directors and officers. Courts in and outside Delaware have signaled that indemnification obligations created by con-tracts with third parties in this setting are not subject to this statutory constraint and therefore could potentially require indemnification for bad faith conduct. Thus, acquirers agreeing to provide indemnification to target fiduciaries “to the full-est extent permitted by law” may find themselves on the hook for latent loyalty breaches unlikely to come to light until after the execution of the acquisition agreement (if not after closing).

As discussed below, there is a different line of authority suggesting that agreements to indemnify for intentional misconduct may be unenforceable on public policy grounds, but the courts have yet to explore or define the contours of those com-mon law limits in the director and officer setting. Until the common law limits on director and offi-cer indemnification are better understood, the key takeaway for acquirers and their advisers is evi-dent: acquisition agreements should make clear that the acquirer’s indemnification obligations are limited in scope to conduct that could be indemni-fied by the target (i.e., those within the province of Section 145). Sellers, on the other hand, may seek to impose broader indemnification obligations where possible. Acquirers considering or agreeing to provide indemnification “to the fullest extent permitted by law” should therefore proceed on an informed basis with their eyes wide open after weighing the potential risks.

Company Indemnification for Directors and officers

Section 145(a) of the DGCL authorizes Dela-ware corporations to indemnify their own direc-tors and officers (so-called “Company Indemnifi-cation”) “against expenses (including attorneys’ fees), judgments, fines and amounts paid in settle-ment” in lawsuits brought by third parties, but

only if the directors and officers “acted in good faith and in a manner [they] reasonably believed to be in or not opposed to the best interests of the corporation.”3 Delaware courts have interpreted Section 145(a) “as not authorizing the use of con-tracts to grant advancement and indemnification rights that are ‘contrary to the limitations or pro-hibitions set forth in the other section 145 sub-sections, other statutes, court decisions, or pub-lic policy.’”4 Thus, a Delaware corporation may only indemnify one of its own directors or officers where the director or officer acted in good faith and in a manner he or she reasonably believed to be in or not opposed to the best interests of the corporation.

Third-Party Indemnification for Directors and officers

The statutory limits imposed by Section 145 on a corporation’s ability to indemnify its own direc-tors and officers do not expressly apply in other contexts. Thus, an indemnification obligation owed by another entity (so-called “Third-Party Indemnification”) operates beyond the express scope of Section 145 in a context where the only potential limits on indemnification arise from common law.5 Accordingly, unless limited by common law, Third-Party Indemnification poten-tially allows indemnification for breaches of the fiduciary duty of loyalty involving scienter, includ-ing claims involving willful misconduct.

The Distinction Between Company Indemnification and Third-Party Indemnification in Case Law

At least three court decisions have contrasted the potential differences between Company In-demnification governed by Section 145 and Third-Party Indemnification in acquisition agreements. While none of the cases delved substantively into the issue, all three recognized the possibility that acquirers may be able to extend indemnification rights beyond the limits of Section 145.

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Louisiana Municipal Police Employees’ Retirement System v. Crawford

The Delaware Court of Chancery commented on the indemnification rights of the directors of Caremark Rx, Inc. (“Caremark”) in litigation challenging CVS Corporation’s acquisition of Caremark at a time when Caremark was em-broiled in litigation arising out of the alleged backdating of stock options.6 The governing merger agreement contained a provision in which CVS agreed to indemnify Caremark’s directors to “the same extent such individuals [would be] indemnified pursuant to Caremark’s certificate of incorporation” or “the fullest extent permitted by law.”7 As noted by then-Chancellor Chandler, the indemnification rights of the former Caremark di-rectors were “not merely coterminous with Care-mark’s former indemnification, but span[ned] ‘the fullest extent permitted by law,’ [which] may be quietly critical.”8

The Court explained that while a “corporation may only indemnify its own directors to the ex-tent that a director acts in good faith and in the best interests of the corporation and, therefore, may not eliminate or limit the liability of a direc-tor who acts in violation of their duty of loyalty,”9 “[i]ndemnity owed to former Caremark directors from CVS/Caremark . . . arguably arises under contract law and outside the restrictions of statu-tory corporate law.”10 The Court further recog-nized that “[i]n effect, CVS shareholders [we]re offering to indemnify Caremark directors,”11 and observed that “[w]ere a backdating case later to come to trial, Caremark directors would almost certainly argue that Delaware statutory law puts no direct limitation on such beneficence.”12

Indiana State District Council of Laborers v. Brukardt

In Indiana State District Council of Laborers v. Brukardt,13 a Tennessee appellate court held that a third-party corporate acquirer (Fresenius Medical Care AG) was not bound by the restric-tions of Section 145 and therefore could indem-nify the defendant directors and officers of Renal Care Group, Inc. for “breaches of the duty of loyalty and good faith.”14 Relying on Crawford,

the Court held that a merger provision providing indemnity “to the fullest extent permitted by law” would operate to indemnify the target company’s fiduciaries for those breaches.15 As explained by the Court:

[A]s a matter of Delaware law, Renal Care could only indemnify defendants for “acts in good faith and in the best interests of the corporation.” But Fresenius, as a third party indemnifying Renal Care directors, is not bound by “the restrictions of statutory corporate law” and can extend indemnifi-cations to defendants for breaches of the duty of loyalty and good faith. In other words, the indemnification offered by Fre-senius covers defendants’ liability for op-tion backdating, a breach of the duty of good faith, whereas the indemnification offered to defendants by Renal Care could not.16

In re Massey Energy Co. Derivative and Class Action Litigation

Then-Vice Chancellor Strine noted the same distinction flagged in Crawford and Brukardt in stockholder litigation challenging Alpha Natural Resources Inc.’s (“Alpha”) acquisition of Massey Energy Co. (“Massey”).17 The original draft of the merger agreement proposed by Massey “re-quired Alpha to indemnify the Massey defen-dants for any claim asserted against them in their capacity as Massey directors or officers ‘to the fullest extent permitted by Law.’”18 The Court emphasized that “the draft merger agreement’s indemnification provision arguably could have al-lowed Alpha, because it was a third-party and not Massey itself, to indemnify former Massey man-agement and directors beyond the extent Massey itself would have been permitted under Delaware public policy and statutory law.”19 Alpha resist-ed this broad obligation in the negotiations, and Massey ultimately agreed that its directors and of-ficers would only be permitted “the same protec-tion they were afforded by Massey’s certificate of incorporation.”20 According to the Court, “[t]his [formulation] did not immunize Massey directors



or officers from liability to Massey or Alpha for non-exculpated breaches of fiduciary duty that harmed Massey.”21

A Result Envisioned by the Drafters of Section 145?

Although the Crawford, Brukardt and Massey courts envisioned the possibility of indemnifica-tion beyond the limits contemplated by Section 145, the commentators who participated in the creation of that statutory section apparently did not. In recommendations that provided the back-bone of the 1967 revisions to the DGCL, Profes-sor Ernest Folk emphasized that “[w]hile indem-nifying executives for many risks of office is . . . to be favored, this objective is not satisfactorily achieved by wording the indemnification statute so broadly that its language authorizes indemnifi-cation in obviously inequitable situations.”22 Sim-ilarly, Samuel Arsht and Walter Stapleton noted in their commentary on the 1967 amendments that “revision was appropriate with respect to the lim-itations which must necessarily be placed on the power to indemnify in order to prevent the statute from undermining the substantive provisions of the criminal law and corporation law.”23 Obvi-ously, to the extent that Third-Party Indemnifica-tion could fill the void created by Section 145’s limits on Company Indemnification, it could un-dermine what these commentators described as the purpose of Section 145’s limits.24

Trap for the Unwary or Tempest in a Teapot?

The emphasis in Crawford, Brukardt and Massey on the distinction between Company In-demnification and Third-Party Indemnification suggests that courts are at least willing to enter-tain the possibility of indemnification for conduct that fails to satisfy the standard of conduct re-quirements embedded in Section 145. However, none of the cases examined common law limits on indemnification. Those limits could be inter-preted to minimize, eliminate or even reverse the distinction raised in Crawford, Brukardt and

Massey between Company Indemnification and Third-Party Indemnification.

In James v. Getty Oil Co.,25 the Delaware Supe-rior Court emphasized that “[a] contract to relieve a party from its intentional or willful acts is in-variably held to be unenforceable as being against clear public policy.”26 The Restatement (Second) of Contracts (the “Second Restatement”) simi-larly provides that “[a] term exempting a party from tort liability for harm caused intentionally or recklessly is unenforceable on grounds of pub-lic policy.”27 If either of the tenets articulated in James or the Second Restatement is the common law of Delaware, then Third-Party Indemnifica-tion might in fact be narrower (rather than broad-er) than Company Indemnification. Stated differ-ently, Section 145 could be read to abrogate more restrictive common law limits on indemnification by expressly authorizing indemnification for in-tentional, willful and reckless acts, so long as the indemnitee acted in good faith and in a manner he or she reasonably believed to be in or not op-posed to the best interests of the corporation.28

Resulting Risk for Acquirers Last year’s well-publicized decision in In re El

Paso Corporation Shareholder Litigation29 high-lights the risks posed to acquirers in this context. El Paso arose out of Kinder Morgan’s agreement to acquire the El Paso Corporation for more than $35 billion. Stockholder plaintiffs argued that El Paso’s CEO, who negotiated the deal on behalf of El Paso and was thus charged with maximizing value for the company’s stockholders, privately coveted the exploration and production (“E&P”) division of El Paso that Kinder Morgan intended to divest after the merger. The stockholder plain-tiffs claimed that this supposed interest, and the failure to disclose conversations surrounding it, tainted the sales process.

Although Chancellor Strine denied the stock-holder plaintiffs’ motion for a preliminary in-junction, he expressed serious concern over these claims. As explained by the Chancellor, “for an MBO to be attractive to management and to Kinder Morgan, not forcing Kinder Morgan to pay the highest possible price for El Paso was

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more optimal than exhausting its wallet, because that would tend to cause Kinder Morgan to de-mand a higher price for the E&P assets.”30 Based on the preliminary injunction record before him, the Court concluded that “the supposedly well-motivated and expert CEO entrusted with all the key price negotiations kept from the Board his in-terest in pursuing a management buy-out of the Company’s E&P business.”31 In short, “when El Paso’s CEO was supposed to be getting the maxi-mum price from Kinder Morgan, he actually had an interest in not doing that.”32

The evidentiary record before the Chancellor at the preliminary injunction stage was necessarily limited, and El Paso’s CEO ardently contested—and intended to vigorously defend—plaintiffs’ claims. But crediting those claims solely for illus-trative purposes, a duty of loyalty breach would have been a distinct possibility.

Critically, long before any allegations of this undisclosed interest had come to light, Kinder Morgan entered into a merger agreement with a provision that obligated it to indemnify El Paso’s directors and officers “to the fullest extent per-mitted under applicable law.” Specifically, Section 5.8(b)(i) of the governing merger agreement re-quired Kinder Morgan to:

indemnify and hold harmless against any cost or expenses (including attorneys fees), judgments, fines, losses, claims, dam-ages or liabilities and amounts paid in set-tlement in connection with any Proceeding, and provide advancement of expenses to, all Indemnified Persons to the fullest ex-tent permitted under applicable Law.33

Thus, while Section 145 would have prohibited El Paso from indemnifying its CEO for a breach of the duty of loyalty, Kinder Morgan as a third-party buyer arguably would have had indemni-fication obligations. This risk was neither trivial nor academic: the Chancellor expressly stated that El Paso’s CEO might be liable for damages in the hundreds of millions of dollars.

ConclusionEliminating similar risk for acquirers going for-

ward is simple and straightforward (at least as a drafting matter). Acquirers and their advisors need only make clear in their acquisition agree-ments that buy-side indemnification obligations are limited in scope to conduct that could be indemnified by the targets (i.e., those within the scope of Section 145). To the extent that targets resist, acquirers should only accede to expansive “to the fullest extent permitted by law” indemni-fication language with knowledge of the potential risks, at least until the Delaware courts definitive-ly address the scope of the common law limits on Third-Party Indemnification in the director and officer setting.

noTES1. See Robert m. Daines & olga Koumrian,

Shareholder Litigation Involving Mergers and Acquisitions, CoRneRsTone ReseARCh(February 2013 update), available at http://www.cornerstone.com/files/news/b8ef7851-5ff6-4247-aaf3-7b211080adc2/Presentation/newsAttachment/7d8db313-246d-4015-b075-94075aae2c39/Cornerstone_Research_shareholder_Litigation_Involving_m_and_A_Feb_2013.pdf,at1(“Continuingarecenttrend,shareholders challenged the vast majority ofm&Adeals in2012.Amongdealsvaluedover$100million,93percentwerechallenged,withanaverageof4.8lawsuitsfiledperdeal....Fordeals valuedover$500million, 96percentoftargetfirmsreporteddeal-relatedlitigationintheirsecuritiesandexchangeCommission(seC)filings...,withanaverageof5.4lawsuitsperdeal.”).

2. 8Del. C.§145(a).3. 8 Del. C. § 145(a). section 145(a) provides

in its entirety as follows: A corporation shall have power to indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than an action by or in the right of the corporation) by reason of the fact that the person is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorney’s fees), judgments, fines and amounts



paid in settlement actually and reasonably incurred by the person in connection with such action, suit or proceeding if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person’s conduct was unlawful. The termination of any action, suit or proceeding by judgment, order, settlement, conviction, or upon a plea of nolo contendere or its equivalent, shall not, of itself, create a presumption that the person did not act in good faith and in a manner which the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had reasonable cause to believe that the person’s conduct was unlawful.Incontrasttosection145(a),acorporationhasno power under section 145(b) to indemnify“amounts paid in settlement” in an actionbrought“byorintherightofthecorporation”(e.g.,aderivativeactionbroughtonbehalfofthecorporation).See 8 Del. C. § 145(b).

4. Sun-Times Media Grp., Inc. v. Black, 954 A.2d380,404n.93(Del.Ch.2008)(quotingCochran v. Stifel Fin. Corp., 2000 WL 286722, at *18(Del.Ch.mar.8,2000),rev’d on other grounds,809A.2d555 (Del.2002)); see also In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 65-66(Del. 2006) (“To oversimplify, subsections (a)and (b)of [section145]permit a corporationtoindemnify. . .where(amongotherthings). . . thatperson ‘acted ingoodfaithand inamannerthepersonreasonablybelievedtobeinornotopposedtothebestinterestsofthecorporation”); VonFeldt v. Stifel Fin. Corp.,1999WL413393,at*2(Del.Ch.June11,1999)(“[A]s far as § 145 is concerned, Delawarecorporations lack the power to indemnify apartywhodidnotact ingoodfaithor inthebestinterestsofthecorporation.”).

5. See, e.g., Pike Creek Chiropractic Ctr., P.A. v. Robinson, 637 A.2d 418, 419-20 (Del. 1994)(enforcing an indemnification provisionwhereby an employee agreed to indemnifyhis employer for any liabilities “whichresult from any acts and [omissions] of theemployee”); Agassi v. Planet Hollywood Int’l, Inc., 269 B.R. 543, 552 (D. Del. 2001)(enforcing several celebrities’ contractualindemnification rights where the contractprovidedforreimbursementofattorneys’fees“arising from or in any way relating to thefinancing[,] promotion or operation of therestaurants”) (emphasis omitted). This privateorderingamong commercialparties is subjectonly to policy constraints. See, e.g., Davis v.

R.C. Peoples, Inc., 2003 WL 21733013, at *4n.24(Del.super.Ct.July25,2003)(statingthatpartiescanobtaincontractualindemnificationfor their own negligence if the contractprovisionsare“crystalclearandunequivocal”)(quotingState v. Interstate Amiesite Corp.,297A.2d41,44(Del.1972)).notably,Delawarelawimposesoneadditionalstatutorylimitationonindemnification in 6 Del. C. § 2704, but thislimitationexpresslyappliesonlytoobligationsinconstructioncontractspurportingtoprovideindemnification for damages arising fromliability for bodily injury or death caused by,resultingfrom,orarisingfromthenegligenceoftheindemniteeorothers.

6. Louisiana Mun. Police Emps.’ Ret. Sys. v. Crawford,918A.2d1172(Del.Ch.2007).

7. Id.at1180(emphasisadded).8. Id.at1180n.8(emphasisadded).9. Id.(emphasisomitted).10. Id.11. Id.12. Id.13. 2009WL426237(Tenn.Ct.App.Feb.19,2009).14. Id.at*12.15. Id.(emphasisadded).16. Id.17. In re Massey Energy Co. Deriv. & Class Action

Litig.,2011WL2176479(Del.Ch.may31,2011).18. Id.at*16(emphasisadded).19. Id.20. Id.at*17.21. Id.22. ernestL.Folk, III,ReVIeWoFTheDeLAWARe

CoRPoRATIonLAW76(1967);see also id.at77(emphasizingthat“tooeasy indemnification”mightundercutfiduciaryduties”).

23. s. samuel Arsht & Walter K. stapleton,Delaware’s New General Corporation Law: Substantive Changes, 23 Bus. LAW. 75, 77-78(1967).

24. Courts and commentators have emphasizedthe same point when interpreting the “non-exclusivity” clause in section 145(f) of theDGCL, which expressly provides that “[t]heindemnificationandadvancementofexpensesprovidedby,orgrantedpursuantto,theothersubsectionsofthissectionshallnotbedeemedexclusive of any other rights to which thoseseeking indemnification or advancementof expenses may be entitled under anybylaw, agreement, vote of stockholders ordisinterested directors or otherwise.” See,e.g., ernest L. Folk, III, Corporation Law Developments—1969, 56 VA. L. ReV. 755, 775(1970) (noting that cases “seem to imposesome limitations on indemnity under thenon-exclusivity clause so as not to destroythe standards carefully articulated elsewhere

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in the statute”); Waltuch v. Conticommodity Servs., Inc.,833F.supp.302,309(s.D.n.Y.1993)(“[T]here would be no point to the carefullycrafted provisions of section 145 spellingout the permissible scope of indemnificationunder Delaware law if subsection (f) allowedindemnification in additional circumstanceswithout regard to these limits. Theexceptionwould swallow the rule.”), aff’d in relevant part,88F.3d87(2d.Cir.1996).

25. 472A.2d33(Del.super.Ct.1983).26. Id. at 38 (citing 15 WILLIsTon ConTRACTs

§1750A(3ded.).27. ResTATemenT (seConD) oF ConTRACTs

§ 195 (1981). When considering thepotential application of § 195 of the secondRestatement, at least two issues warrantmention.First,thelanguagethatcouldbereadto limit indemnificationexpresslyappliesonlyto “torts,” and there is lingering uncertaintyabout whether a breach of fiduciary dutyshould be deemed a “tort,” an “equitabletort,” a breach of contract, or somethingelse.See J.TravisLaster&michelleD.morris,Breaches of Fiduciary Duty and the Delaware Uniform Contribution Act,11DeL.L.ReV.71,88-93(2010).second,inananalogouscontext,the Court of Chancery has expressly declinedto adopt the rule set out in § 195. See Abry Partners V L.P. v. F&W Acquisition LLC, 891A.2d1032,1064(Del.Ch.2006)(holdingthatacontractual provision purporting to exculpateasellerwhomadecontractualrepresentationsand warranties that it knew at the timewere false was unenforceable as a matter ofpublicpolicy,but thata contractualprovisionpurporting to exculpate a seller who actedina recklessmannerwasenforceable). In thewords of then Vice-Chancellor strine in Abry:“IrecognizethatIamdrawingadifferentlinethan§195oftheRestatementbydrawingthelineatliesratherthanrecklesslyconveyedfalsestatements.IdosobecauseIthinkitbothmoreefficientandfaironlytooverrideacontractuallimitation on liability when that limitationwould exonerate an actual liar or someonecomplicitinalie.”Id.at1063n.82.

28. Indemnification“tothefullestextentpermittedbylaw”underDelaware’sLPandLLCstatutesislikelyfarmoreexpansive.See6Del. C. §18-108(providing that, “[s]ubject to such standardsand restrictions, if any, as are set forth in itslimitedliabilitycompanyagreement,alimitedliabilitycompanymay,andshallhavethepowerto, indemnifyandholdharmlessanymemberormanagerorotherpersonfromandagainstanyandallclaimsanddemandswhatsoever”);6 Del. C. § 17-108 (providing that, “[s]ubjectto such standards and restrictions, if any, as

are set forth in its partnership agreement, alimited partnership may, and shall have thepower to, indemnify and hold harmless anypartnerorotherpersonfromandagainstanyand all claims and demands whatsoever”).notably, this language could be read toabrogatethepotentialcommonlawlimitsonindemnificationaddressedinthissection.

29. 41A.3d432(Del.Ch.2012).30. Id.at444.31. Id.at443.32. Id.at434.33. emphasisadded.section5.8(d)ofthemerger

Agreementfurtherprovidedthat“[t]herightsof any Indemnified Person under this section5.8shallbeinadditiontoanyotherrightssuchIndemnifiedPersonmayhaveunder thenewePsurvivingCorporationCertificate, thenewePsurvivingCorporationBy-Laws,theDGCLortheDLLCA.”



A Hard Case Makes Good Law: Meso Scale Diagnostics, LLC v. Roche Diagnostics GmbHB y J O N A T h A N E . l E v I T s k y A N D D m I T r I y A . T A r T A k O v s k I y

Jonathan Levitsky is a partner and Dmitriy A. Tartakovskiy is a counsel in the New York office of Debevoise & Plimpton LLP. Contact: [email protected] or [email protected].

Justice Holmes famously observed that “hard cases…make bad law,”1 an adage that was neatly avoided in the Delaware Court of Chancery’s recent ruling in Meso Scale Diagnostics, LLC v. Roche Diagnostics GmbH.2 The case challenged a broadly-held assumption of M&A practitioners that has been historically less settled than many may have assumed—that the acquisition of a tar-get company through the common “reverse tri-angular merger” structure does not result in the assignment of the contracts of the target by op-eration of law or otherwise.

The issue is important because while most com-mercial contracts prohibit assignment without the consent of the counterparty, provisions granting a termination right or other remedy in the event of a change of control are less common. Since in a reverse triangular merger a transitory merger sub-sidiary of the acquirer merges with and into the target company, with the target company surviv-ing, the typical view is that no assignment of the target’s contracts has occurred even though the tar-get has experienced a change of control. As a con-sequence, reverse triangular mergers are generally thought to require fewer third-party consents than transactions structured as forward mergers or as-set purchases, an important element in the appeal of this structure. Where the relevant contracts are material to the business, the need for such consents

can be an important issue, giving the contractual counterparties hold-up value over the deal and creating transaction costs and uncertainty. In some instances, buyers may insist that obtaining coun-terparty consents for key contracts be a closing condition, or the allocation of the cost of failing to obtain necessary consents may be a matter for negotiation between the parties.

The Delaware Court of Chancery reaffirmed in Meso Scale the M&A bar’s prevailing view on this issue. Vice Chancellor Parsons held that, under Delaware law, a reverse triangular merger where the target is the surviving entity generally does not result in an assignment by operation of law of a contract that is held by the surviving en-tity both before and after the merger. The deci-sion clarified confusion resulting from the Vice Chancellor’s own previous ruling in the same case (denying a motion to dismiss), in which he had suggested (apparently influenced by the “hard facts” of the case described below) that a reverse triangular merger might constitute an assignment by operation of law in certain circumstances.

BackgroundMeso Scale arose out of a series of license agree-

ments pursuant to which the defendants, Roche Holding Ltd. and certain of its affiliates, licensed from BioVeris Corporation a patent portfolio. One of the BioVeris-Roche license agreements granted plaintiff Meso Scale Technologies, LLC certain rights with respect to the technology li-censed to Roche, and contained a provision pro-hibiting any assignment by BioVeris of its rights to the licensed technology “by operation of law or otherwise” without Meso’s prior written con-sent. The assignment provision did not, however, expressly require Meso’s consent to a change of control or ownership of BioVeris.

As a result of several lawsuits challenging Roche’s license to the patent portfolio, Roche ul-timately decided to acquire BioVeris in order to retain its rights to use the licensed technology. The acquisition was structured as a reverse triangular merger, in which a wholly owned subsidiary of Roche was merged with and into BioVeris, with BioVeris surviving the merger, and was completed

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without Meso’s consent. Following the comple-tion of the merger came the events that appear to have given the court pause—Roche discontinued BioVeris’ product lines, closed down its research and development plant and terminated its em-ployees, retaining only title to the technology for-merly licensed to Roche. Meso brought a claim for breach of contract, alleging that the merger constituted an assignment by operation of law of BioVeris’ rights to the patent portfolio, which required Meso’s prior consent under the license agreement.

Roche promptly moved to dismiss the action for failure to state a claim, arguing that a reverse tri-angular merger could never constitute an assign-ment by operation of law under Delaware law. In a memorandum opinion dated April 8, 2011, Vice Chancellor Parsons denied the motion.3

Noting that no Delaware case squarely ad-dressed the issue, the Vice Chancellor stated that because the plaintiffs alleged that BioVeris was essentially gutted and converted into a shell com-pany to hold the valuable licenses for Roche’s benefit following the merger, there could be an is-sue of fact as to whether the parties to the license agreement intended Roche’s actions to constitute an assignment “by operation of law or other-wise” forbidden under the license, which could not be resolved on a motion to dismiss.

Ruling of the Delaware Court of Chancery

In September 2012, Roche moved for summary judgment, arguing among other things that the BioVeris merger did not constitute an assignment by operation of law in violation of the license agreement. Focusing on the issue more closely, Vice Chancellor Parsons agreed with Roche’s in-terpretation of the anti-assignment provision and granted the motion.

(A) Delaware merger statute makes clear that a reverse triangular merger is not an assignment

In reaching its conclusion, the court first ana-lyzed the provisions of Delaware’s corporation

statute describing the legal effect of a merger. In particular, the court noted the statute provides that a merger results in the transfer of the non-surviving corporation’s rights and obligations to the surviving corporation by operation of law. Reasoning by negative implication, the court con-cluded that no assignment or transfer of the rights and obligations of the surviving corporation oc-curs as a result of the merger. Accordingly, the court held that a reverse triangular merger gener-ally is not an assignment, by operation of law or otherwise, of assets held by the surviving entity both before and after the merger, and therefore, the term “by operation of law or otherwise” used in the license agreement made clear that the par-ties did not intend the anti-assignment provision to apply to reverse triangular mergers.

(B) Roche’s interpretation is consistent with the reasonable expectations of the parties

The court also held that Roche’s interpretation of the anti-assignment provision was consistent with the reasonable expectations of the parties to the license agreement. The court observed that leading commentators have noted that a reverse triangular merger does not constitute an assign-ment or transfer of a target company’s assets by operation of law, which is a reason this transac-tion structure is a preferred method of acquisi-tion in a wide range of transactions. Based on that commentary, the court concluded that it was unlikely that the parties would have expected the anti-assignment provision in the license agree-ment to apply to reverse triangular mergers.

(C) Forward triangular mergers distinguished

In support of its claims, Meso argued that the court should look to prior Delaware cases that held that a provision covering assignment by op-eration of law extends to all mergers.4 However, Vice Chancellor Parsons found that the cases cit-ed by the plaintiffs were distinguishable because they involved forward triangular mergers where the target was not the surviving entity, whereas



this case involved a reverse triangular merger in which BioVeris was the surviving entity. The court instead analogized reverse triangular merg-ers to stock acquisitions—which, by themselves, do not result in an assignment by operation of law under Delaware law. Vice Chancellor Parsons reasoned that both stock acquisitions and reverse triangular mergers involve changes in legal own-ership, and therefore, the law governing these transactions should reflect parallel results.

Practical ImplicationsThe Meso Scale decision has resolved the un-

certainty created by the court’s 2011 ruling on the motion to dismiss and reaffirmed the prevailing understanding among M&A practitioners that, under Delaware law, a transaction structured as a reverse triangular merger will not trigger anti-assignment provisions that do not expressly pro-hibit a change of control. Different outcomes may be possible, however, in other jurisdictions.

Indeed, the Meso Scale court declined to adopt the approach outlined in a 1991 federal case, SQL Solutions Inc. v. Oracle Corp.,5 cited by the plaintiffs. In that case, the U.S. District Court for the Northern District of California held that a re-verse triangular merger constituted an assignment of a software license, noting a federal interest in protecting holders of intellectual property rights licensed to third parties. In rejecting the plaintiffs’ argument that Delaware should adopt the same rule, Vice Chancellor Parsons noted that the SQL Solutions approach would be inconsistent with Delaware’s case law on stock acquisitions. SQL Solutions was recently cited favorably by the U.S. District Court for the District of New Jersey in DBA Distribution Services, Inc. v. All Source Freight Solutions, Inc.6 In that case, the court determined, interpreting a contract governed by New Jersey law, that a provision barring assign-ment by operation of law was violated by a re-verse triangular merger.

Counsel should not over-weight the importance of these decisions. Both SQL Solutions and DBA Distribution are unreported rulings that were not intended to have precedential effect. These deci-sions also pre-date Meso Scale, which given the

Delaware Court of Chancery’s role as a preemi-nent forum for the resolution of business disputes is likely to be given substantial weight in other ju-risdictions. Where the preservation of a contract is of key importance to a target business, acquir-ers and their counsel should nonetheless proceed with appropriate care.

noTES1. Northern Securities Co. v. United States, 193

u.s.197(1904).2. C.A.no.5589-VCP,memoop.(Del.Ch.Feb.22,

2013).3. Meso Scale Diagnostics, LLC v. Roche Diagnostics

GmbH,C.A.no.5589-VCP,memoop.(Del.Ch.Apr.8,2011).

4. Theplaintiffsreliedprimarilyontwocasesforthatproposition:Star Cellular Telephone Co. v. Baton Rouge CGSA, Inc.,1993WL294847(Del.Ch.Aug.2,1993),aff’d,647A.2d382,1994WL267285 (Del. 1994), and Tenneco Automotive Inc. v. El Paso Corp.,2002WL453930(Del.Ch.mar.20,2002).

5. C.A. no. 91-1079, 1991 WL 626458 (n.D. Cal.Dec.18,1991).

6. C.A.no.11-3901,2012WL845929(D.n.J.mar.13,2012).

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“Don’t Ask, Don’t Waive”:Standstill Provisions in Light of Recent Delaware CasesB y s C O T T m . F r E E m A N , G A B r I E l s A l T A r E l l I A N D r O B E r T J . h I G G I N s

Scott Freeman and Gabriel Saltarelli are partners, and Robert Higgins is an associate, in the New York office of Sidley Austin LLP. This article expresses the views of the authors and does not necessarily represent the views of Sidley Austin LLP. Contact: [email protected] or [email protected] or [email protected].

Most confidentiality agreements entered into by public companies in connection with merger discus-sions (in an auction or otherwise) include standstill provisions that prohibit potential acquirers from making unsolicited offers for some period of time. Many of these provisions prohibit the potential acquirer from even asking the target company to waive a prohibition in order to permit the potential acquirer to make a friendly acquisition proposal. The Delaware courts have recently scrutinized the use of such “don’t ask, don’t waive” (“DADW”) standstill provisions. Recent bench rulings in the Delaware Chancery Court suggest that, because DADW standstill provisions are powerful tools, they should be used only under close supervision by the board of directors. We believe that, in most cases, the DADW standstill provisions should be drafted to permit the potential acquirer to make unsolicited acquisition proposals privately to the board of directors if the target company enters into a merger agreement with another party. This approach allows the target’s directors to meet their ongoing obligation to evaluate all relevant infor-mation when deciding whether to continue to rec-ommend the merger agreement to shareholders, in keeping with their fiduciary duties under Delaware law, and in fact is generally consistent with maxi-mizing value for shareholders.

Treatment of Standstill Provisions by the Delaware Courts

While DADW standstill provisions have been analyzed on numerous occasions by the Delaware courts, the courts’ treatment of these provisions has been inconsistent and has left open questions as to the appropriate use and the enforceability of DADW standstill provisions in the sale process.

In re Complete Genomics In In re Complete Genomics Inc. Shareholder

Litigation, Vice Chancellor Laster compared DADW standstill provisions to bidder-specific no-talk clauses, which prohibit a target not only from soliciting superior offers or providing infor-mation to third parties, but also from communi-cating with third parties about a sale of the target.1 Vice Chancellor Laster found that “by agreeing to this [DADW] provision, the Genomics board impermissibly limited its ongoing statutory and fiduciary obligations to properly evaluate a com-peting offer, disclose material information, and make a meaningful merger recommendation to its stockholders.”2 It is worth noting that Vice Chan-cellor Laster, in his oral ruling on November 9, 2012, denied the plaintiffs’ request for a prelimi-nary injunction barring Genomics from enforc-ing the standstill (as it was obligated to do under the merger agreement) because, at that time, he “understood that each standstill agreement pre-vented the counterparty from publicly requesting or proposing that the company or any of its rep-resentatives amend, waive, or consider amending or waiving any of its terms, but did not prevent the counterparty from making a non-public re-quest.”3 The defendants, however, subsequently submitted a letter advising that the standstill for “Party J” contained a DADW standstill provision that prevented a party from making a non-public request for a waiver to the board. Vice Chancel-lor Laster felt this prevented the Genomics board from being able “to take into account that request and any of its terms when evaluating its ongoing statutory and fiduciary obligations to determine whether to continue to recommend in favor of the merger”4 and he enjoined Genomics from en-

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forcing the “Don’t Ask Provision, insofar as such term purports to forbid Party J from seeking, in a non-public manner, a waiver of the terms of the Standstill Agreement.”5

In re CeleraIn In re Celera Corporation Shareholder Liti-

gation,6 the court commented on DADW stand-still provisions in the context of approving a proposed settlement. Vice Chancellor Parsons separately analyzed and acknowledged the poten-tially value maximizing benefits of both DADW standstill provisions in confidentiality agreements and non-solicitation (or “no-shop”) provisions in merger agreements. He noted that “[t]aken together, however, the Don’t-Ask-Don’t-Waive Standstills and No Solicitation Provision are more problematic …”7 The court found the interplay of the DADW standstill provision with the non-solicitation provision troubling because, on the one hand, the DADW standstill provision blocks once-interested parties from informing the tar-get board of their desire to bid and, on the other hand, the non-solicitation provision prevents the board from inquiring further into any potential interest from those parties. The result is that there is “at least a colorable argument that these con-straints collectively operate to ensure an informa-tional vacuum … [and increase] the risk that the Board would outright lack adequate information argu[ably] emasculat[ing] whatever protections the No Solicitation Provision’s fiduciary out oth-erwise could have provided.”8 Vice Chancellor Parsons found that such “willful blindness” could mean the target board “would lack the informa-tion to determine whether continued compliance with the Merger Agreement would violate its fiduciary duty to consider superior offers” and even went so far as to say that merely “contract-ing into such a state conceivably could constitute a breach of fiduciary duty.”9

In re Ancestry In the most recent Delaware decision, In re An-

cestry,10 Chancellor Strine struck a different note with respect to DADW standstill provisions, hold-ing that they are not per se invalid and that they

can be used to encourage auction participants to make the fullest possible bids, but that their use should be monitored by the Board and dis-closed to shareholders in the proxy statement.11 The court noted that Genomics and Celera were not per se invalidations of DADW standstill pro-visions, but the courts’ treatment of them should serve as an acknowledgement of the potency of these provisions and resultant obligation of directors to use them very carefully, such that their use remains consistent with the directors’ fiduciary duties.12 The court did not rule out the possibility that these provisions can be used as a “gavel” to maximize shareholder value; however, what troubled him was that (i) it was “obviously shown that this board was not informed about the potency of this clause … [t]he CEO was not aware of it … [and] it’s not even clear the banker was aware of it”13 and (ii) failing to disclose the existence of these provisions in the proxy state-ment created “a false impression that any of the folks who signed the standstill could have made a superior proposal.”14 Chancellor Strine enjoined the shareholder vote pending disclosure of the use of the DADW standstill provisions.15

DADW Standstill Provisions and the Auction Process

The Delaware courts have made clear that “there is no single blueprint that a board must follow to fulfill its duties” in selling a company.16 Nonetheless, certain patterns have emerged. An auction process often begins with an initial round in which a limited number of potential bidders are invited to provide indications of interest. This initial round is followed by successive rounds, where a relatively small number of bidders are al-lowed to perform due diligence and are invited to make more definitive offers. The field is narrowed by eliminating low bidders and bidders that are viewed as unlikely to be able to complete a trans-action. At the end of the process, the remaining bidders are asked to submit “best and final” offers. This last stage is similar to a first price, sealed-bid auction, in that each bidder does not know what the other bidders are offering, and the company is sold to the highest bidder at the price



offered by that bidder. In practice, the “best and final” round is often followed by further nego-tiations and one or more losing bidders may be offered an opportunity to outbid the presumptive winner from the “best and final” round. The re-sult is that a real-world auction may include fea-tures of both a first price, sealed-bid auction and an open outcry auction.17

Despite (or perhaps because of) the assertion by Delaware courts that there is no single blueprint for selling a company, the vast majority of public company merger agreements include “fiduciary out” provisions, allowing the board of directors to inform itself regarding potential superior pro-posals, and to terminate the merger agreement to accept a superior proposal, subject to payment of a reasonable termination fee.18 As a practical matter, this means that the last step in almost ev-ery sale process (following announcement of an executed merger agreement) is an open outcry auction in which the announced acquirer serves as a stalking horse. From the acquirer’s perspec-tive, this is problematic because it creates uncer-tainty as to whether it will be able to complete the acquisition at the agreed price. From the target’s perspective, this is problematic because it under-mines the best and final sealed-bid auction that the target thought it ran prior to executing the merger agreement. One purported advantage of the sealed-bid auction is that uncertainty regard-ing the competing bids discourages a bidder from holding back its best price, thereby increasing the likelihood that the final price will represent the best price of the bidder who places the highest value on the company. In contrast, in an open out-cry auction, the company would be sold at a price only slightly higher than that of the bidder who places the second-highest value on the company. If there is a large gap between the values placed on the company by the top two bidders, the open outcry auction can leave significant value on the table. Because the fiduciary out effectively con-verts almost every auction for a public company into an open outcry auction, the effectiveness of the target company’s “best and final” sealed-bid process is undermined. If a bidder believes that its best price may be significantly higher than the second-highest bid, it might be inclined to hold

something back, knowing that if it bids too low and loses it will have another chance to submit a topping bid after the merger agreement is signed (subject, of course, to payment of a termination fee to the stalking horse bidder).

In response, some target companies and acquir-ers have subverted the open outcry auction that typically follows the announcement of a merger agreement by excluding the most likely bid-ders—those that participated in the initial auc-tion. This has been accomplished by requiring (i) prospective bidders to agree to DADW standstill provisions that survive the execution of a merger agreement with a third party and (ii) including a provision in the merger agreement prohibiting the target from waiving the standstill.19

Whether DADW standstill provisions that re-main in place after the auction process encourage auction participants to put forward their best bid during the auction process is a subject of debate. The Delaware courts have abstained from tak-ing a position on the value-maximizing role of DADW standstill provisions, stating only that it is possible these provisions play a value-maximiz-ing role.20 While we concede that, as a theoretical matter, DADW standstill provisions that remain in place after the signing of a definitive agreement can play a value-maximizing role by encourag-ing bidders to make their “best and final” offers in the auction (because they will be unable to make a topping bid following the conclusion of the auction),21 we reject that notion as a practi-cal matter. Our view stems from our consistent experience that auctions in the public company target context are not conducted as pure “sealed-bid” auctions, in which the bidders do not have some sense of the competing bids and the “final” bids remain final.22 Rather, a target’s investment bankers will often keep competing bidders ap-prised of where the top bids are (at least approxi-mately) in an effort to get them to increase their respective bids above the then-current highest bid.23 Furthermore, because the vast majority of merger agreements include a fiduciary out, and the enforceability of DADW standstill provisions is uncertain, bidders understand that, in most in-stances, a merger agreement will not necessarily end the auction. We therefore find predictions

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that requiring DADW standstill provisions to fall away at the signing of a definitive agreement “may affect the way sophisticated parties engage in auctions, and even their willingness to do so”24 to be unduly alarmist.

Some may disagree with our premise on the grounds that, even if the bankers do provide such information, because there is no way for a bidder to verify the information, these bankers’ updates have little effect on what a bidder will offer in response to such “coaching.” While we acknowl-edge that there is no way to verify the information in real time, we disagree that this dynamic does not have a significant impact on the sale process because bidders will know, after the fact, from the proxy statement whether the banker was truthful (about the high bid they need to beat).25 As these auctions are not single iteration games for the players involved, a banker who misleads bidders with regard to the amount of another bid would presumably suffer reputational harm and thus inhibit his or her ability successfully to conduct auctions in the future.

The Way ForwardBecause target companies may provide confi-

dential information to a relatively large number of prospective bidders, standstills serve the im-portant purpose of preventing these potential bid-ders from using the confidential information to launch a hostile tender offer or proxy contest, in the event the target chooses not to sell itself.26 The need for DADW standstill provisions, however, is reduced once the company has determined to sell itself and entered into a definitive merger agree-ment. As discussed above, we believe in most cases the utility of DADW standstill provisions as a gavel in the auction process is limited. Accord-ingly, it makes sense to permit potential bidders to make private offers, or to request waivers, once the target has entered into a merger agreement.

Drafting the private offer portions of the DADW standstill provisions to terminate automatically upon signing a definitive merger agreement af-fords parties the benefit of using them during the auction process (i.e., to conduct the auction in a controlled way) while, at the same time, avoiding

the problematic interplay, as illustrated in Celera, with the non-solicitation and enforcement-of-standstill provisions of the merger agreement. Such automatic termination also ensures that a target board has the opportunity to comply with its fiduciary obligation to remain adequately in-formed. This approach has the added benefit of making it unnecessary for the target to attempt to resist the covenant in the merger agreement to en-force the DADW standstill provisions (something which can be difficult) since the private offer por-tions of the DADW standstill provisions will have been drafted to terminate automatically upon the execution of a definitive agreement.27 The result is that a public company auction is similar to a Sec-tion 363 bankruptcy sale. The acquirer that signs a merger agreement is essentially a stalking horse bidder. The stalking horse has the benefit of rea-sonable deal protections, such as matching rights and a break-up fee, but otherwise recognizes that the deal is open to being topped by an interloper.

We note that other commentators have ad-vocated that more restrictive DADW standstill provisions should “be paired with a minimal fi-duciary out that would allow bidders bound by the standstill to request a waiver if certain clearly articulated new information were to come to light.”28 We disagree with this prescription be-cause the fact that a bidder wishes to submit a topping bid is, in and of itself, new information that the board, in keeping with its fiduciary duty to remain informed on an ongoing basis, needs to keep itself apprised of, regardless of the un-derlying reasons for any such bid. For example, a potential bidder might change its own strategy (perhaps in response to a competitor announcing a merger agreement with the target) in a way that makes the target more attractive than it was at the time of the auction, even in the absence of new information about the target. If this were the case, presumably the target board would have a duty to inform itself.

We recommend that, as a minimum, the DADW standstill provisions should fall away upon ex-ecution of a definitive merger agreement so as to allow another bidder to go privately to the target board with an offer. An alternative would be to allow public, as well as private, offers. The benefit



of forcing bidders to go privately to the target’s board with a proposal is that it allows the board to control public disclosure of the offer. This may be particularly important if an offer appears at-tractive on the surface because it is at a higher price than the merger agreement, but is otherwise unattractive to the board (e.g., because it raises regulatory issues such that it is unlikely to be con-summated). While in many cases any such private offer should be disclosed by the company in the proxy statement (or a supplement thereto), or other disclosure document, practitioners should weigh the benefits of requiring the bidder to ap-proach the company privately against any poten-tial benefits to the stockholders from allowing a bidder to tell its side of the story.29

A target company that seeks to bind poten-tial acquirers to DADW standstills that survive a merger agreement faces a number of risks. First, the target company may create an uneven playing field in any bidding that occurs after the merger agreement is signed. Some bidders might ignore the provision, believing that it is unenforceable or that any breach of the DADW standstill will not result in damages recoverable by the target. Others might honor the provision to avoid litigation or because they have a policy of honoring their agreements. As a result, the bidder with the highest value might not partici-pate in any post-signing bidding activity. Sec-ond, a court might scrutinize the process lead-ing to the company’s decision to require such standstills, including the board’s involvement (or lack thereof), and might find the process wanting as in Ancestry. Finally, a court might find that the combination of the DADW stand-stills and the non-solicitation covenant in the merger agreement amount to a breach of fidu-ciary duty as suggested in Celera and Genom-ics. All these risks are eliminated if the original standstill agreements permit bidders to make offers and request waivers after a merger agree-ment is signed.30 Accordingly, we think that well-advised targets generally will not seek to prevent parties that participate in the pre-sign-ing auction from making topping bids after a merger agreement is signed.

noTES1. See In re Complete Genomics Shareholder

Litigation (C.A. 7888-VCL, Del. Ch. november27, 2012) at 14. See also Phelps Dodge Corporation v. Cyprus Amax (C.A. no. 17427,Del Ch. 1999) stating that no-talk clauses“are troublingpreciselybecause theypreventa board from meeting its duty to make aninformed judgment with respect to evenconsideringwhethertonegotiatewithathirdparty” (Phelps at 34) and finding that for aboardtocompletelyforeclosetheopportunitytocommunicatewiththirdparties“isthelegalequivalent of willful blindness, a blindnessthat may constitute a breach of a board’sduty of care; that is, the duty to take careto be informed of all material informationreasonablyavailable.”Id.at35.

2. See alsoIn re The Topps Company Shareholder Litigation, 926 A.2d 58, 62 (Del. Ch. 2007),statingthat“astandstillcanbeusedbyatargetimproperly to favoronebidderoveranother,not for reasons consistent with stockholderinterest …” and enjoining the shareholdervoteuntilaftertheToppsboardgrantedupperDeck a waiver of its standstill. See also In re RehabCare Group Inc. Shareholder Litigation(C.A. no. 6197-VCL, Del. Ch. september 8,2011) at 46, stating that the “agree not toask” portion of the standstill “optically looksbad when you’re reviewing deal facts” andexpressing doubt that such a provision “isevergoingtoholdupif it’sactually litigated,particularly after Topps … [and further] thatit doesn’t give you [the target board] anyultimatebenefitbecauseyouknowthepersoncangetaToppsrulingmakingyouletthemask,at a minimum, [for a waiver of the standstillprovision]orask inabackchannelway.”See also In re Bioclinica, Inc. Shareholder Litigation(C.A.no.8272-VCG,Del.Ch.February25,2012),inwhichthecourtseemstoacceptthepremisethatatargetcompanycannotexcludepartiesthat sign nDAs from bidding after a mergeragreement is signed, stating “[i]f the factsunderlyingthisparagraph[fromthePlaintiff’sReplyBrief]weretrue,thePlaintiffsmayhavestateda colorable claim justifyingexpedition.A deal-protection tool that could both (1)relegate a bidder to making a tender offer,without approaching the board of directors,andthen(2)triggertheonerousprovisionsofapoisonpilluponthemereannouncementofsuchatenderoffercouldindeedprecludeabidfromanypartythathadsignedsuchannDA.”

3. Genomicsat11-12.4. Id.at12.

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5. see order Granting In Part Plaintiffs’ motionForaPreliminaryInjunction(Del.Ch.December4,2012).

6. In re Celera Corporation Shareholder Litigation(C.A.no.6304-VCP,Del.Ch.2012).

7. Celeraat53.8. Id.at53-54.9. Id.ViceChancellorParsonsalso,forthesakeof

clarification, stated that he was not going sofarasfindingthat“provisionsexpresslybarringa restricted party from seeking a waiver of astandstillnecessarilyareunenforceable.”Id.at54.

10. SeeIn re Ancestry(C.A.no.7988-Cs,December17,2012)at224-225.

11. ChancellorstrinealsotookpainstopointoutthatAncestrywasabenchruling,statingthat“[b]ench rulings are limited rulings. They’retime-pressured ones … and because they’retime pressured, they shouldn’t make broadlaw....”Id.at222.

12. Id.at224.13. Id.at227.14. Id.at228.15. The Ancestry board waived the “don’t ask”

portion of the DADW on December 11, 2012followingthefilingofthelitigationchallengingthe provision. Chancellor strine stated that,if these provisions are to be used as a gavel,“thentheelectorateshouldknowthat…theyshouldunderstandthatthere isa segmentofthe market where that segment cannot takeadvantage of [the ability to make a superiorproposal]”(Ancestryat230).Chancellorstrinealsoindicatedthathewouldhavesentaletterto all the auction bidders the “nanosecond”aftersigningthedefinitiveagreementwaivingthe DADW provision to make “clear to all ofthem[theotherbidders]iftheywishtoaskforawaiverinordertomakeasuperiorproposalthat they are legally allowed to do so (Id. at231).ofcourse,thatassumesthatthemergeragreement signed the nanosecond beforedoesn’t prohibit such a waiver, as many nowdo.See“TheWayForward”inthetext, infra.since,inAncestry,theDADWhadalreadybeenwaivedbytheboard,Chancellorstrine’srulingwas limited todisclosure surrounding theuseof the DADW provision in the process. Webelievethereforethatobserverswhoconcludethat “[t]he Ancestry ruling reaffirms [that]… [c]ontracts, including standstills, will berespectedandenforcedaswritten”may takethisrulingfurtherthantheyshould.See, e.g.,Trevor s. norwitz, Igor Kirman and Williamsavitt, “‘Don’t Ask, Don’t Waive Standstills’ Revisited (Rapidly),”Wachtell,Lipton,Rosen&Katz,December28,2012.Itisnotatallcertainthatastandstillprovisionwouldbeenforcedas

written if the court concludes that it isbeingusedimproperly(asinTopps)orwithoutcarefulconsiderationbytheBoard(asinAncestry).

16. See Barkan v. Amsted Indus., Inc., 567 A.2d1279,1286(Del.1989).

17. See Guhan subramanian, Deal Making: The New Strategy of Negotiauctions(W.W.norton& Company, Inc., 2010), Chapter 4 “ChoosingtheRightKindofAuction.”

18. See, e.g., In re OPENLANE, Inc. Shareholders Litigation (C.A.no.6849-VCn) (Del.Ch.2011)atfootnote53,statingthat“Omnicaremaybereadtosaythattheremustbeafiduciaryoutineverymergeragreement.”

19. See, e.g., section 5.3 of the Agreementand Plan of merger among BGI-shenzen,Beta Acquisition Corporation and CompleteGenomics,Inc.,datedasofseptember15,2012,stating, in relevant part, that the Company(including its subsidiariesandrepresentatives)shall not “waive, terminate, modify, fail toenforce or release any Person other thanParent or the Purchaser from any provisionoforgrantanypermission,waiveror requestunderany‘standstill,’confidentialityorsimilaragreement or obligation… .” The court inGenomics seemedtoreject this tacticwhen itenjoinedthe“don’task”portionoftheDADWprovisioninsofarasitpurportedtoforbidoneof the bidders in the auction from making anon-publicrequestforawaiverofitsstandstill.seeourdiscussionofIn re Genomicsinthetext,supra. But cf. Ancestry, in which Chancellorstrine found that DADW provisions were notper seinvalidandthatsuchprovisionscouldbeusedtoencouragethefullestpossiblebidsbyauctionparticipants,butstatingthattheiruseshouldbemonitoredbytheboardofdirectorsanddisclosedintheproxystatement.SeeourdiscussionofIn re Ancestryinthetext,supra.

20. See, e.g., Ancestry,inwhichChancellorstrine,in discussing DADW standstill provisions,stated “I’m not prepared to rule…that they[DADWstandstillprovisions]can’tbeusedforvalue-maximizing purposes. But the value-maximizing purpose has to be to allow thesellerasawell-motivated seller touse itasagavel,toimpressuponthepeoplethatithadbrought into the process the fact that theprocessismeaningful.”Ancestryat225.

21. Forpurposesofthisarticle,weassumethattheDADWprovisionhasa“directlyor indirectly”clause, such that the provision prohibits apotentialloserintheauctionfromtellingthetarget board, “But for the DADW, we wouldrequest a waiver of the standstill to permitus to offer you $X per share… .” We alsoignore the question of whether damages are



recoverable in the event of a breach of theDADWstandstill.

22. For a discussion of various types of auctions,including,amongothers,“sealed-bidauctions,”seeChristinam.sautter,“Auction Theory and Standstills: Dealing with Friends and Foes in a Sale of Corporate Control”DRAFT,January26,2012, at 20-26 (electronic copy available at:http://ssrn.com/abstract=2207693).

23. howoftenhavedealpractitionersheardfromthe target’s banker, “you need to bid $X inordertostayintheauction”?

24. Trevor s. norwitz, Igor Kirman and Williamsavitt,“‘Don’t Ask, Don’t Waive Standstills’ and the Auction Problem,”Wachtell,Lipton,Rosen&Katz,november30,2012.

25. See, e.g., Presidential Life Corporation(schedule 14A at 35-36) (november 15,2012) (in which, after the Presidential Lifeboard subcommittee concluded that PartyA’s proposal was superior to that of Athene,”[t]he subcommittee decided to informAthene that the Company had received aproposal superior to Athene’s most recentproposal and that the subcommittee may bein a position to recommend to Presidential’sboard of directors execution of that superiorproposalshortly.sandlero’neillaskedAthenetowithdrawcertainrequestedchangestothemergeragreementandincreaseitsofferpricepershare…”).

26. standstills are also important to the extentthey prohibit a losing bidder from publiclychallenginganannouncedmergeragreementwithout making a new bid, which is why weproposethatcertainportionsofthestandstill(e.g.,thoseprohibitingthelosingbiddersfrommakingpubliccommunications,wagingproxycontests and effecting share accumulations)should continue following execution of amergeragreement.

27. once the winning bidder has been selectedby the target, it isoftendifficult fora targetto resist the winning bidder’s request for acovenantinthemergeragreementprohibitingthe target from waiving any standstillagreement.

28. See sautter DRAFT at 74. sautter advocatesthat, in sucha case,ahigher termination feeshouldapply.

29. TheDelawarecourtshavearguablypresentedinconsistent views on the importance ofallowing a topping bidder to go public withits offer. See e.g., Topps, in which then ViceChancellorstrinenotesthat“ToppswentpublicwithstatementsdisparagingupperDeck’sbidand its seriousness but continues to use thestandstill to prevent upper Deck from tellingitsownsideofthestory.TheToppsboardseeks

tohavetheToppsstockholdersaccepteisner’sbidwithouthearingthefullstory.Thatisnotaproperuseofastandstillbyafiduciarygiventhecircumstanceshere.Rather,itthreatenstheToppsstockholderswithmakinganimportantdecision on an uninformed basis…” (Toppsat 64-65). But cf. Genomics, suggesting thatallowingabiddertoprivatelymakeanofferissufficientfortheboardtomeetitsobligationsto remain informed on an ongoing basis(Genomicsat11-12).

Inadditiontomerelytellingitssideofthestory,abiddercouldalsobeallowedtotakeitsofferdirectly to the shareholders by launching ahostiletenderoffer.WenotethatwaivingtheDADWstandstillprovisionsinsuchawayastoallowabiddertolaunchahostiletenderofferwould not preclude the target board fromsubsequently adopting defensive measuresinresponsetoatenderoffer.See e.g., Topps,inwhichthecourtnotedthat“upperDeck isnotevenaskingforsomesortofpriorrestraintpreventingtheToppsboardfromimplementinga rights plan in the event of a tender offer.”Topps at 64. The court, however, furtheracknowledges thatupperDeckhad indicatedthattheadoptionofarightsplaninthefaceof a tender offer would begin a new roundoflitigationbetweentheparties.Becausetheadoptionofdefensivemeasuresinthefaceofatenderofferwouldbereasonablylikelytoleadtolitigationbetweenthebidderlaunchingthetenderofferandthetarget,whethertowaivethestandstilltosuchanextentshouldalsobeevaluatedonacasebycasebasisbythetargetboardanditsadvisors.

30. Thisapproachalsoensuresconsistenttreatmentofallbidders.

The M&A Lawyer



The Uncertain Relationship Between Fiduciary Waivers & the Implied Covenant of Good Faith in Delaware Alternative Entity LawB y k r I s h N A v E E r A r A G h A v A N A N D J A s O N s . T y l E r

Krishna Veeraraghavan is a partner and Jason S. Tyler is an associate in the New York office of Sullivan & Cromwell. Contact: [email protected].

Delaware alternative entity law—i.e., the Re-vised Uniform Limited Partnership Act (“LP Act”)1 and the Limited Liability Company Act (the “LLC Act”)2—explicitly intend “to give maximum effect to the principle of freedom of contract” by allowing limited partnership (“LP”) and limited liability company (“LLC”) agreements to expand, restrict, or eliminate du-ties “(including fiduciary duties)” that a person might owe to an LP or LLC.3 The only condition placed on this otherwise broad endorsement of private ordering is that alternative entity agree-ments “may not eliminate the implied contrac-tual covenant of good faith and fair dealing.”4 Consistent with this statutory authority, numer-ous LP and LLC agreements expressly disclaim fiduciary duties. As a result, these agreements limit the duties of general partners and managers to complying with the agreements’ express and implied terms, seemingly eschewing the more searching Revlon or entire fairness standards of review applicable to corporate directors’ conduct in approving mergers or self-interested transactions, respectively.

The importance of this contractual freedom is difficult to overstate. For example, in an em-

pirical study of publicly traded LPs5 and LLCs in existence in 2011, only one was organized under the laws of a jurisdiction other than Delaware.6 Furthermore, just shy of 90% of those publicly traded Delaware alternative entities “either to-tally waive the fiduciary duties of managers or eliminate liability arising from the breach of fi-duciary duties.”7 A reasonable inference from this data is that the very ability to modify, or at least to exculpate from monetary liability for breaching, the traditional duties of care and loy-alty afforded by the LP and LLC Acts is what at-tracts business planners to Delaware alternative entities in the first instance.

The ProblemNevertheless, a number of class actions chal-

lenging mergers and other conflict transactions involving alternative entities recently have been brought in the Delaware Court of Chancery due to an apparent conflict in Delaware’s implied covenant doctrine.8 One line of implied covenant cases, best represented by the Delaware Supreme Court’s majority decision in Nemec v. Shrader,9 characterizes the implied covenant as a mecha-nism to “infer[] contractual terms to handle de-velopments or contractual gaps that. . .neither party anticipated,”10 but that therefore “can-not be used to circumvent the parties’ bargain, or to create a free-floating duty. . .unattached to the underlying” contract.11 A second line of cases, best represented by the Delaware Supreme Court’s decisions in Dunlap v. State Farm Fire & Casualty Co.12 and Desert Equities, Inc. v. Morgan Stanley Leveraged Equity, II, L.P.,13 however, characterizes the implied covenant in broader terms, as an “obligation to preserve the spirit of the bargain rather than the letter.”14 “[G]overned solely by ‘issues of compelling fair-ness,’”15 the implied covenant—according to this second line of cases—“requires more than just literal compliance” with the express con-tract and positive law, but also “act[ing] in a way that honors the [other party]’s reasonable expectations.”16 Among other things, this ex-pansive characterization of the implied covenant has been interpreted in an unbroken chain of



cases to require a party exercising contractually conferred discretionary rights “to exercise that discretion in a reasonable manner. Reasonable-ness is a question of fact to be determined by the finder of fact.”17

This broader formulation of the implied covenant appears to invite equitable review of a party’s actions, express contract terms not-withstanding. Take, for example, an LP agree-ment that expressly (1) waives fiduciary duties and (2) permits the general partner to make (or decline to make) all decisions in its sole discre-tion in managing the business, limited only by its subjective belief that its decisions are in the best interest of the partnership. Under the first, narrow line of implied covenant cases, there is no gap for the implied covenant to fill. The parties affirmatively chose to endow the gen-eral partner with discretionary authority to act, and they delineated the scope of that discretion by a subjective belief condition. So long as the general partner subjectively believes it is act-ing in the company’s best interest, the implied covenant cannot override the general partner’s express contractual right to exercise discretion. If, however, the general partner acts with a con-trary subjective belief, then it has breached an express provision of the contract. In either case, the implied covenant is irrelevant.

Under the second, broad line of implied cove-nant cases, by contrast, there is inescapable room for the implied covenant. Because the waiver of fiduciary duties effectively makes every act dis-cretionary, every business decision (i.e., each exercise of contractually-conferred discretion) is susceptible to challenge as having been unrea-sonable. In other words, taking full advantage of the ability to contract out of fiduciary duties ironically seems to result in a “loop” whereby the implied covenant imposes on the general partner a standard of conduct that the contract-ing parties plainly intended to avoid.18 And even more ironic is that this seeming result follows the parties’ invocation of a statutory scheme ex-plicitly intended to encourage private ordering and freedom of contract.

The Fix (?)We say this second line of cases only “seems”

to subject general partners and managers’ busi-ness decisions to a reasonableness standard be-cause the Court of Chancery has been clear that “[t]he implied covenant is not a substitute for fiduciary duty analysis.”19 Nevertheless, reason-ableness challenges of this sort are “tempting” to plaintiffs20 and, while the Delaware courts have expressed antagonism to grafting purely equi-table principles onto the implied covenant,21 the Court of Chancery has not yet settled on a singu-lar, logical framework that cogently disposes of reasonableness challenges in the alternative entity context, nor has the Delaware Supreme Court yet affirmed any of the various frameworks that the Court of Chancery has attempted thus far. There are at least two strains of reasoning that the Court of Chancery has employed in recent months to ensure this doctrinal ambiguity does not under-mine clear contractual provisions intended to pre-clude searching equitable challenges to alternative entity managers’ conduct.22

(1) Strict Interpretation of the “Gap Filler” Line of Cases

In Gerber 2012, Vice Chancellor Noble adopt-ed a strict interpretation of Nemec’s directive that the implied covenant cannot override an express contractual right. Among other things, that case challenged a sale by a master limited partnership of one of its subsidiaries to an affiliate of the gen-eral partner for allegedly $1 billion less than the subsidiary’s fair value, i.e., a classic self-dealing transaction. Although the limited partnership agreement required that any transactions with af-filiates be “fair and reasonable,” the agreement also provided for, and the general partner fol-lowed, a “Special Approval” process: if the inde-pendent directors of the general partner approved the self-interested transaction, then it would be deemed “fair and reasonable.” Because the use of that Special Approval process was discretionary, however, the Court held that the general partner “had a duty, under the implied covenant, to act in good faith if it took advantage of the Special Approval process.”23

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Nevertheless, the partnership agreement also contained a provision that any action in reliance on an expert’s opinion “shall be conclusively pre-sumed” to have been done in good faith, and the general partner had received a fairness opinion from Morgan Stanley that the consideration re-ceived in the transaction was fair from a financial point of view to the partnership and its limited partners. As the Court wrote,

The drafters of the LPA [i.e., the limited partnership agreement] foresaw that claims against [the general partner] assert-ing a failure to act in good faith could arise in a number of circumstances. The drafters decided that none of those claims could be asserted if [the general partner] acted in reliance upon the opinion of an expert. Under the LPA, [the general partner] has an “express contractual right” to rely upon the opinion of an expert and thereby be conclusively presumed to have acted in good faith. The Court may not “infer lan-guage that contradicts a clear exercise” of that right. Although the well-pled facts of the Complaint may suggest that [the general partner] breached the implied cov-enant, that claim is precluded by Section 7.10(b) of the LPA.24

In a footnote, the Court added:

This conclusion raises the question: how can a section of the LPA preclude a claim for breach of the implied covenant when 6 Del. C. § 17-1101(d) provides that a “part-nership agreement may not eliminate the implied contractual covenant of good faith and fair dealing?” The answer is that al-though the covenant of good faith and fair dealing may sound like some grandiose principle, it is a gap-filler. . . .

[A]s the Supreme Court has explained [in Nemec], if a contract has no gaps, then the implied covenant is not applicable to that contract. A limited partnership agreement may not validly state that “the implied covenant is not part of this agreement,”

but if a limited partnership agreement sim-ply has no gaps, then the implied covenant will never apply to that agreement.

The LPA provides that if [the general part-ner] follows a specific procedure, then any gaps that may appear in the LPA will be filled with a conclusive presumption of good faith. When [the general partner] caused [the partnership] to undertake the 2009 Sale, it followed that specific proce-dure in deciding whether to take advan-tage of the Special Approval process. Thus, any possible gap that [the plaintiff] might be able to find in the use of the Special Approval process will be filled with a con-clusive presumption of good faith. There can be no claim that [the general partner] breached the implied covenant.25

While the Court’s explanatory footnote reflects a faithful interpretation of Nemec, it also—as the Court itself acknowledged—“take[s] the reader and the writer to the outer reaches of conduct al-lowable under 6 Del. C. § 17-1101.”26 Moreover, the distinction that it draws between the imper-missible term “the implied covenant is not part of this agreement” and the supposedly permissible term “if X, then no claims predicated on bad faith may be brought” ultimately may be untenable. Consider, for example, the following hypotheti-cal term: “If the Manager is validly elected by the Members, then it is entitled to a conclusive pre-sumption of good faith for every action it takes until the next Manager elections.” Such a provi-sion also purports to fill in all gaps, but neverthe-less reduces to an unlimited conferral of discretion in managing the affairs of the business. Perhaps the salient distinction is the degree of specificity required before a conclusive presumption is pos-sible: in Gerber 2012, the general partner had to follow a prescribed process of submitting the transaction to a committee of independent direc-tors, the qualifications for whom also were pre-scribed by the LPA, for their Special Approval before a conclusive presumption would attach; in the hypothetical provision just posited, the process for obtaining the presumption is entirely



open-ended. Of course, if the degree of specificity is the salient detail, then the courts nevertheless likely will find themselves in a lengthy sequence of litigation seeking to clarify exactly where the line of “specific enough” is drawn.

(2) Revaluation of the “Reasonableness” Lines of Cases

A second line of cases has not relied on such a strict reading of Nemec. Instead, these cases have attempted to reconcile the reasonableness requirement with Nemec by using the general scheme of the particular contract as the gauge against which the reasonableness of discretionary determinations are to be evaluated in any given case. For example, the facts of Encore Energy are similar to those of Gerber 2012. In Encore Energy, the general partner approved a merger27 of the partnership into the general partner’s con-trolling shareholder after seeking and obtaining Special Approval from an independent commit-tee, who relied on an investment bank’s fairness opinion that the consideration was fair to the unaffiliated unitholders. The plaintiffs neverthe-less challenged the good faith of the transaction, alleging that the independent committee’s agree-ment to a premium of less than 1% of the units’ preannouncement trading price reflected a lack of meaningful, good faith negotiations with the controller.

After concluding that the Special Approval process fulfilled the express contract provisions, Vice Chancellor Parsons turned to the plaintiffs’ claim that the general partner did not exercise its discretion to use Special Approval in good faith. First, the Court emphasized reasoning from Dunlap, the leading “reasonableness” case, that the implied covenant does not impose a “free-floating duty.” Rather, the Court relied on Vice Chancellor Laster’s then-recent ASB Allegiance opinion that:

“[f]air dealing” is not akin to the fair pro-cess component of entire fairness, i.e., whether the fiduciary acted fairly when engaging in the challenged transaction as measured by duties of loyalty and care. . . .It is rather a commitment to deal “fairly”

in the sense of consistently with the terms of the parties’ agreement and its purpose. Likewise “good faith” does not envision loyalty to the contractual counterparty, but rather faithfulness to the scope, pur-pose, and terms of the parties’ contract. Both necessarily turn on the contract itself and what the parties would have agreed upon had the issue arisen when they were bargaining originally.28

The Encore Energy Court then held that Dela-ware’s implied covenant doctrine “disclaim[s]” a duty of objective fairness, and instead required the plaintiffs to “identify how the Conflicts Commit-tee’s allegedly feckless negotiations ‘frustrate[d] the fruits of the bargain that the [parties] reason-ably expected’” at the time of contracting.29 Hav-ing determined to evaluate the “reasonableness” of the general partner’s actions against the general contract scheme, the Court had little difficulty concluding that the limited partnership agreement was “inimical to requiring that a transaction re-ceiving Special Approval be objectively fair and reasonable.”30 Indeed, the Court found that the limited partnership agreement “plainly intended to give the General Partner and its Affiliates max-imum flexibility. Under these circumstances, an inference that the concededly modest protections afforded to Plaintiffs by the LPA frustrated their legitimate expectations would be unreasonable even on a motion to dismiss.”31Accordingly, the Court dismissed the implied covenant claim.32

Encore Energy’s reasoning is susceptible to some doubt, in that it made no attempt to address the holding of Desert Equities that, not only must contractual discretion be exercised reasonably, but “[r]easonableness is a question of fact.”33 Or-dinarily, a court cannot decide questions of fact on a motion to dismiss, which the Encore Energy Court implicitly did in concluding that the gener-al partner’s use of Special Approval to immunize the merger was reasonable. Thus, while Encore Energy arguably is a sound attempt to reconcile Delaware’s implied covenant doctrine in a man-ner consistent with the LP and LLC Acts, it does not resolve the continuing conflict in Delaware’s implied covenant doctrine.

The M&A Lawyer



The ImplicationsThe import for business planners of this con-

cededly nuanced doctrinal landscape is that alter-native entities—even those that expressly disclaim fiduciary duties—are susceptible to greater litiga-tion risk than may be apparent. To be clear, the Court of Chancery appears committed to hon-oring express waivers of fiduciary duties in the context of deal litigation involving alternative entities, and we do not believe there is a signifi-cant risk of plaintiffs prevailing under any of the “seeming” theories we discussed above. That is, it is not the risk of liability that is underappreciated.

Rather, the risk is that Delaware’s implied cov-enant doctrine “seems” to open a backdoor to fi-duciary review that, as the Court of Chancery has described it, is “tempting” to plaintiffs and plain-tiffs’ firms. Furthermore, until that backdoor de-finitively is shut, unaffiliated equity holders have at least a colorable legal theory on which to initi-ate litigation against alternative entities and those who manage them. It is, thus, this legitimate risk of being sued—and all of the attendant legal fees, distraction, and uncertainty litigation causes—that is underappreciated by business planners and may undermine a supposed advantage of the al-ternative entity form in the first instance. This is especially true for publicly traded alternative enti-ties, which often operate in the oil and gas indus-try, because of plaintiffs’ firms incentive to pursue representative actions on behalf of large classes of dispersed equity holders, but the legal uncertainty applies to alternative entities generally regardless of size, industry, or capital structure.

noTES1. 6Del. C.§§17-101to17-1111[hereinafterLP

Act].2. 6Del. C.§§18-101to18-1109[hereinafterLLC

Act].3. LPAct§17-1101(c), (d);LLCAct§18-1101(b),

(c).4. LPAct§17-1101(d);LLCAct§18-1101(c).5. Publicly tradedLPsoftenarerenamedmaster

limited partnerships, or mLPs. This changein appellation, however, does not affect thelegal framework undergirding the entities’organization and internal affairs. Rather, inDelaware,theLPActcontinuestocontrol.

6. mohsen manesh, Contractual Freedom underDelaware Alternative entity Law: evidencefromPubliclyTradedLPsandLLCs,37J.Corp.L.555,598n.236(2012).

7. Id.at557.8. See, e.g., Gerber v. EPE Hldgs., LLC,2013 WL

209658 (Del. Ch. Jan. 18, 2013) [hereinafterGerber 2013]; In re Encore Energy P’rs LP Unitholder Litig., 2012 WL 3792997 (Del. Ch.Aug. 31, 2012); In re K-Sea Transp. P’rs L.P. Unitholder Litig.,2012WL1142351(Del.Ch.Apr.4,2012); Gerber v. Enter. Prods. Hldgs.,LLC,2012WL 34442 (Del. Ch. Jan. 6, 2012) [hereinafterGerber 2012]; Brinckerhoff v. Enbridge Energy Co., Inc., 2011 WL 4599654 (Del. Ch. sept. 30,2011)[hereinafterenbridgeenergy];In re Atlas Energy Res., LLC, 2010 WL 4273122 (Del. Ch.oct. 28, 2010); Lonergan v. EPE Hldgs., LLC, 5A.3d1008(Del.Ch.2010);Brinckerhoff v. Tex. E. Prods. Pipeline Co., LLC,986A.2d370(Del.Ch.2010) [hereinafterTePPCo]. Itshouldbenotedthatlitigationimplicatingtheimpliedcovenantinthealternativeentitycontextextendsbeyonddeallitigation.Forexample,therelativelyrecentcaseofPolicemen’s Annuity & Benefit Fund of Chi. v. DV Realty Advisors LLC,2012WL3548206(Del.Ch.Aug.6,2012),concernedwhetherthelimited partners validly removed the generalpartner of a Delaware LP, a question whichturned on whether contractually conferreddiscretionhadbeenexercisedreasonablyunderthe implied covenant, see infra note 17 andaccompanyingtext.

9. The mere fact that Nemec was decided by aslim 3-2 majority itself is noteworthy, in thatonlyrarelydoestheDelawaresupremeCourtdecideacaseotherthanunanimously.

10. Nemec v. Shrader, 991 A.2d 1120, 1125 (Del.2010).

11. Dunlap v. State Farm Fire & Cas. Co.,878A.2d434,441(Del.2005)(internalquotationmarksomitted).

12. 878A.2d434,441(Del.2005).13. 624A.2d1199(Del.1993).14. Dunlap,878A.2dat444.Forthesakeofclarity,

Dunlap did not concern the interpretation ofan alternative entity operating agreement, orevenofamergerorothercomplextransactionagreement,butofanindividualmotorinsurancepolicy. nevertheless, because the LP and LLCActs intend to treat operating agreements asordinarycontracts,thetypeofcontractinvolveddoesnotmeanthatDunlapisirrelevanttotheinterpretationofalternativeentityagreements.In any event, Desert Equities did involve theinterpretationofanLPagreement.

15. Id.at442(emphasisadded)(quotingCincinnati SMSA Ltd. P’shp. v. Cincinnati Bell Cellular Sys. Co.,708A.2d989,992-93(Del.1998)).



16. Id.at444.17. Desert Equities, 624 A.2d at 1206; see also

Encore Energy,2012WL3792997,at*12(“whena contract confers discretionary rights on aparty,theimpliedcovenantrequiresthatpartytoexerciseitsdiscretionreasonably”(emphasisadded)(citingASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC,50A.3d434,441 (Del.Ch. July9,2012));Airborne Health, Inc. v. Squid Soap, LP, 984A.2d 126, 146-47 (Del. Ch. 2009) (“When acontract confers discretion on one party, theimplied covenant requires that the discretionbeusedreasonablyandingoodfaith.”).

18. Furthermore, Delaware courts often use theterm“reasonablenessreview”interchangeablywiththeenhancedjudicialscrutinyprescribedbyRevlonandUnocalforcertainextraordinarycorporate decisions, meaning the impliedcovenant’s reasonableness standard for evenordinary business decisions arguably is moreonerousthanthatfacedbycorporatedirectorsundertraditionalfiduciaryduties.See, e.g., In re Toys “R” Us, Inc. S’holder Litig., 877 A.2d975, 1000 (Del. Ch. 2005) (“[T]he supremeCourtheldthatcourtswouldsubjectdirectorssubject to Revlon duties to a heightenedstandard of reasonableness review, ratherthan the laxer standard of rationality reviewapplicableunderthebusinessjudgmentrule.”);In re Pure Res., Inc. S’holders Litig., 808 A.2d421, 439-40 (Del. Ch. 2002) (noting defensivemeasures are “subject to a heightened formof reasonableness review under the so-calledUnocalstandard”).

19. Lonergan,5A.3dat1017;accord Gerber 2013,2013 WL 209658, at *11 (citing Lonergan);Encore Energy,2012WL3792997,at*12(citingLonergan).

20. Gerber 2013,2013WL209658,at*11.21. See, e.g., Nemec, 991A.2dat1128 (“[A]post

contracting equitable amendment that shiftseconomicbenefits...wouldvitiatethelimitedreach of the concept of the implied duty ofgoodfaithandfairdealing.”).

22. ItisworthemphasizingthattheseapproachesdonotportendmanagementbiasonthepartoftheDelawareCourtofChancery.AstheCourtnoted in Encore Energy, for example: “Thenear absence under the [limited partnershipagreement] of any duties whatsoever toencore’s public equity holders presumablywould discourage risk averse investorsunwillingtotakealeapoffaithfrominvestingtheirmoneyinanenterprisecontrolledbytheGeneralPartneranditsAffiliates.But,therightto enter into good and bad contracts makesthe implied covenant an ersatz substitutefor the warning ‘caveat emptor.’ Investors

apprehensive about the risks inherent inwaivingthefiduciarydutiesofthosewithwhomthey entrust their investments may be welladvised to avoid master limited partnershipslikeencore.havingdecidedto takea leapoffaith and to reach for the kind of returns amaster limited partnership investment mightyield, however, Plaintiffs cannot reintroducefiduciaryreviewthroughthebackdoorof theimplied covenant.” Encore Energy, 2012 WL3792997,at*13(internalquotationmarksandfootnotes omitted). similarly, in Gerber 2012,the Court observed that, “[i]f the protectionprovided by Delaware law is scant, then theLPunitsofthesepartnershipsmighttradeatadiscount”and,inanyevent,theLPAct’sexpressauthority to waive fiduciary duties reflects alegislative determination “that this Court hasonlya limitedrole inprotectingthe investorsof publicly traded limited partnerships thattake fulladvantageof6Del. C. §17-1101(d),and that is a role this Court must accept.”Gerber 2012,2012WL34442,at*10n.42.

23. Gerber 2012, 2012 WL 34442, at *11. shortlyafterViceChancellornobleissuedGerber 2012,ViceChancellorParsonsadoptedthisreasoninginIn re K-Sea,2012WL1142351,at*9-10.Bothcases are pending appeal to the DelawaresupremeCourt.

24. Gerber 2012,2012WL34442,at*13.25. Id.at*13n.58.26. Id.at*13.27. Althoughthemergeralsorequiredapprovalby

thelimitedpartners,theacquireralreadyhelda significant number of limited partnershipunits, which it insisted on voting in favor ofthe then-pending merger. In other words,the unitholder vote provided no meaningfulprotection to the unaffiliated unitholders inthecircumstancesofthiscase.

28. ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC,50A.3d434,441(Del.Ch.July9,2012).

29. Encore Energy, 2012 WL 3792997, at *12(alterations in original) (quoting Nemec, 991A.2dat1126).

30. Id.31. Id.32. In a role reversal, see infra note 23, Vice

Chancellor noble’s subsequent Gerber 2013opinion drew heavily on Encore Energy’sreasoning. See, e.g., Gerber 2013, 2013 WL209658,at*6n.69(“TheanalysishereisguidedbytheapproachinEncore Energy P’rs”);id.at*11(“ThewordsofIn re Encore Energy Partnersareparticularlyappropriatehere”).

33. Desert Equities,624A.2dat1206.

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